Plan sponsors see big bounce in performance after adding new funds but it doesn't last.

A recent research brief from the Center for Retirement Research at Boston College showed that 401(k) plan administrators have an eye for fund performance when the time comes to update their plan menu options.

Researchers Edwin J. Elton and Martin J. Gruber, both professors emeritus at New York University's Leonard N. Stern School of Business, along with Christopher R. Blake, a professor of finance at Fordham University, examined 43 plans with an average asset size of $310 million between 1994 and 1999. Over that period, the trio analyzed the changes the employers made to their menus. During that period, the plan sponsors added a total of 215 mutual funds and dropped 45 funds. More than half of the additions were of funds from an investment category that wasn't previously represented in the plan's menu.

The research also showed that the newly added funds had particularly strong performance in the three years leading up to the change in the 401(k) menu. Indeed, the performance of the newly added funds beat a randomly selected group of similar funds by 134 basis points annually. Funds that were dropped from plans' menus, meanwhile, underperformed a random group of similar funds by 143 basis points annually.

The boost in returns from plan menu changes was only temporary, however. According to the research, three years after adding on the new funds, the additions beat a random group of similar offerings only by 44 basis points. Dropped funds, on the other hand, experienced a slight improvement in their performance after being removed from the 401(k) menu, besting similar randomly selected funds by 17 basis points.

Gruber noted that poor fund choices by plan sponsors inevitably have a ripple effect on the decisions participants make with the menu options. "Participants tend to allocate inefficiently," he said. "If you give them bad choices, then there is a tendency for them to put more money into those bad choices."

Rather than leaving workers with a large variety of funds that were chosen based on past performance, plan sponsors may want to reconsider their methodology. Gruber suggests that employers consider offering a diverse selection of funds. He added that employees benefit from having the option to choose either a passive or active investment style.

In addition, cost and comparisons of fees should be factors in adding a fund to a lineup. Typically, small to midsize plans don't pay much attention to expenses.

"Don't overpower people with too many choices, but give them enough choices so that they span the major types of securities," he said.